# Thread: Need help understanding bonds (bubble)

1. ## Need help understanding bonds (bubble)

I have really no understanding of bonds, but i've heard that their is/could be a bubble in bonds(Faber,Schiff). I have heard that bonds are long term but people are shorting them. But this makes no since to me. I don't know much about investing and bonds. If anyone could explain this to me (like you would to a child) i would greatly appreciate it.

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3. The US Government issues bonds(treasury bonds or bills). Someone will buy the bond with a guarantee of future payment from the government. For instance they pay \$100 for a 30 year bond and get paid \$4 every year from the government until the end of 30 years where their principle is returned. Treasury bills are a bit different. They work by buying the bill at a discount. For instance they would buy a 3 month bill worth \$100 for 99.80. After 3 months they would receive \$100. Of course these denominations are not correct. I believe \$1000 is the smallest domination, not sure. Schiff believes bond prices are way to high because he believes the dollar will become much weaker in the future due to various reasons. So if the dollar is getting weaker, it will require more dollars to be paid in the future to make it worth purchasing a bond. So for instance, it might only be worth buying a bond if you are paid \$8 or \$12 a year for a \$100 bond. Since the dollar is losing value you will need more to make the purchase worth doing. For this to happen, the price of the bond must drop to \$80 or \$60 or whatever. So now a bond with a 5% coupon(pays \$5 a year for every 100 purchased at par) will only cost \$50 instead of its par value of \$100 and if you still purchase \$100 worth of the bonds you will be getting a 10% return on your money rather than a 5% return because they bought the bonds at half of the par value(par = \$100). Probably didn't explain this too well, but ask questions on things you do not understand.

4. I am no expert, but hopefully i can get you started.

First, you need to know the bonds are referenced in two ways..
1. the yield & 2. the price
these two ways of looking at bonds move inversely with eachother, or in otherwords, when the price of the bond is low then the yield (or interest rate) is high(1980). When the price for the bond is high, then the yield (or interest rate) is low(today).

Its very important to understand that when listening to people talk about bonds/treasuries.

Now the chart I posted above shows the yield, or the interest rate. As you can see, in 1980 treasuries were cheap and the yield was high. But ever since that time the price of treasuries has been rising and the yield dropping. We are now at record low yields, or in other words, record high prices. Eventually they will have to drop in price, or raise interest rates.

From 1980 to now these treasuries have been profitable, because the price has been rising. But if the fed or the market changes and rates rise, that means the price of the bond/treasury is falling.

5. Originally Posted by WilliamShrugged
I have really no understanding of bonds, but i've heard that their is/could be a bubble in bonds(Faber,Schiff). I have heard that bonds are long term but people are shorting them. But this makes no since to me. I don't know much about investing and bonds. If anyone could explain this to me (like you would to a child) i would greatly appreciate it.
This is a simplified version of economic bubbles. A thorough study is warranted if you wish to understand exactly what happened. This is generally the way I understand it.

Think of economic bubbles much like a balloon. The balloon will not expand unless someone forces air into it. In that same way, forcing money into specific investments cause bubbles.

In the early 90s, 401k's were fairly new retirement investment vehicles created by law. 401k investments are tax advantaged. People became allowed, by law, to invest savings from income earnings into the stock market, or other investments, and consequently defer taxes until retirement. The idea was to boost to savings in the U.S. and provide additional retirement money for individuals.

The Internet Tech Stock Bubble

Much of this investment money went to the promising new Internet tech stocks because the government "virtually forced" investment somewhere and tech stocks were a good place for it to go as "gamblers" (otherwise known as financial advisors) bid those stocks up based, not on profits, but on price of stock. One guy said, "I'll buy ABCD.com for \$25, and the next guy said, "I'll pay \$30", and the next guy said, "Ill pay \$40" and so on... up to \$400 or more for some stocks. Even though the ABCD.com Company, INC. never produced a viable product that was sold for a profit, their corporate owners made tons of cash. The company was not a profitable company, yet the first guy in, along with scammers, made millions, and some even made billions. The bubble was blown up from the value of say ... \$25 to \$400+ per share.

Then when people started figuring out that many of the Internet tech companies were not profitable, people pulled their money out of those stocks, and the bubble collapsed. Some people got rich (early investors and owners). The people that made money started looking for a new place to put money since tech stocks weren't doing so well anymore. Enter real estate.

The Real Estate Housing Bubble

Real estate came into the picture real big at the collapse of the Internet tech stock bubble. Real estate had a solid history of being a safe investment, so people started putting their money into real estate. Before long housing prices started to rise and the first ones in started seeing their personal wealth rise. Flipping houses became popular because a smart investor could buy a run-down home for \$75k put \$5k into it and sell it for \$125k. That was a tidy little profit for a couple month's work. Then TV gurus started sharing this "no money down" technique for buying real estate and the house flipping get rich quick went nationwide. New housing was booming too because people like new shiny stuff. Mortgages became easier to get as lenders relaxed lending standards.

Lots of people began making a lot of money. Mortgage lenders, real estate brokers, investment bankers, the whole economy was "hot." Governments began promoting home ownership as the "American dream." Fannie Mae, Freddie Mac, Ginny Mae, HUD, FDIC and other government institutions guaranteed loses to private investors, so lending standards were lowered even more.

By 2005, the "no money down", "stated income", "no document proof" loans were as simple to get as walking into a local mortgage store front (wearing a nice suit) and stating, "I make \$100k per year and want to buy a home." Lender says, "How nice of home do you want?" Borrower says, "How nice of home can I buy?" Lender says, "Do you really make \$100k, or is your income \$135k? Because if you make \$135k then you can buy this brand new home in a gated community on the golf course for \$700k. The developer is an old friend of ours, they build excellent communities, and it looks like you might qualify." Borrower says, "I'm pretty sure that I'm getting a raise next week, and that should put me around \$135k." Let's do it!

Housing prices skyrocketed until the bubble burst in 2007. The housing bubble burst because the borrower did not get his expected raise, and as a matter of fact, did not really make \$100k/year to begin with. So he could not make his payments. Enter the bond market.

The Bond Market Bubble

The bond market has a long stable solid history of being a sound investment. Bonds are typically low yielding but losses are guaranteed by the U.S. Government. Yada... yada... yada... enter what cubical, and others, are saying ... ie. the bond market is building a bubble.

6. Shorting is a way of making money as the price of something drops. If you were shorting a stock, basically you would borrow the stock from someone and then sell it. Then you would hope the price goes down so you can buy it back cheaper and return the borrowed shares. You make money on the difference between the sell and the buy. If you were short Treasury's, you would want to see a higher and higher interest rate.

You can short Treasury's through ETF's. Buy them like a stock. When you buy them, you are short and hope the price of the ETF goes up. Ticker symbols for ETF's that short Treasury's are PST, TBF, and TBT.

You might hear the terms Treasury Bills, Notes, and Bonds.

Bills are less than one year, and as cubical said, you buy them at a discount rather than get paid interest.

Notes are 2-10 years.

Bonds are more than 10 years.

7. During a bubble, demand goes for the product goes up. What drives that demand?

Right now, demand for US government bonds is being driven by the US Government itself via the Federal Reserve.

1. The most publicized way this happens is for the Federal Reserve to directly buy US Bonds from the Treasury (monetizing the debt).

2. The Federal Reserve will also buy bonds in the secondary market. For example, the Chinese buy a bunch of bonds directly from the US Treasury. The Federal Reserve then (almost immediately) buys those bonds from the Chinese (nice profit for the Chinese). It's an arrangement.

3. The least known (and most secretive) method is taking money borrowed from the Federal Reserve at 0% interest, and using that money to buy US government bonds and high quality corporate bonds. This is done by Wall St. "bankers" such as Goldman Sachs and JP Morgan. It's a huge profit, with no risk.

8. Bonds trade inversely to their interest rate.

If I were to buy a \$1000 face value bond for \$900, I would receive \$1000 back at the end of the term, even though I only put up \$900. Likewise, I can pay \$1100 for a \$1000 bond, effectively bidding down the rate of interest.

If in each case the bond were to return \$1500 in interest yields and a return of principle, the first bond would bring 66% returns (Total investment= \$900, total return = \$500 in interest, \$1000 principle, profit of \$600) over the life of the bond, while the second would effectively pay 36% (Total investment= \$900, total return=\$500 in interest, \$1000 in principle, profit of \$400).

The bond bubble matters only for bondholders who do not plan to hold until the end of the term. If I were to buy a \$1000 bond for \$1100, expecting to receive \$1500 in both interest payments and return of \$1000 face value at maturity, I would realize a \$400 gain. However, if interest rates were to rise in the period between the time I purchased, and maturity, I would be holding a paper loss. The bond value may fall to \$900 at market, even though it would still return a full \$1500 by maturity in return of face value and the interest payments along the way. You might want to learn more about bond convexity.

When Schiff says there is a bond bubble, he's basically saying that bond yields are far too low, and investors holding long dated bonds for short term profits are going to get obliterated when rates rise.

9. I just read an article of our only financial newspaper in my country that the ECB is expected to raise interest rates due to inflation fears and that the banks expect the Euribor (Euro Interbank Offered Rate) also to rise because of it.

In the same article they mention record high yields of German bonds.

Can someone please tell me what all of this means?

I mean I thought central banks weren't going to raise rates because if they did people would default on their loans and countries would default on their debt?

EDIT: oh and if I'm right and raising rates would cause all these defaults wouldn't this be an indicator of a short term deflation instead of inflation?

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11. Higher yields come about from lower demand from buyers of the bonds. This means that the bonds sell for lower prices- the difference between the face value of the bond (what it is worth at maturity say \$10,000) and the selling price (say \$9,000). This is the yield and can be expressed as a percent return on the purchase price.

If yields are rising and you hold older bonds, those are now worth more since they offer higher rates of return so you can sell an older bond for a higher price than a newer one. If you have an older bond and the interest yields on newer bonds go up, then if you want to sell yours before it matures, you will have to sell it at a lower price and possibly lose money since you will have to try to match the yield (rate of return) of the current bonds. Why would somebody buy one from you at say three percent when they can buy a brand new one giving them five percent? You will basically have to pay them (a would be buyer) the extra two percent out of your pocket. This is why as interest rates rise, bond funds returns go down- unless they hold their bonds until maturity.

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